Tuesday, March 9, 2010

The Case for, and against, a Trade in Treasuries

Structurally, one can see from the accompanying 5-year chart of TLT (an ETF for the 20-30 year T-bond) closing yesterday at 89.80, it is at one level of multi-year support. Even during the commodities-fueled inflation of the first half of 2008, when oil crossed $140/barrel and gold first passed $1000/ounce, TLT traded in the 90s.

(Click on chart to enlarge.)

Please recall that TLT prices move inversely to interest rates. When bond prices rise, interest rates fall in an opposite pattern.

Not shown here is the well-known 25-30 year bull market trend in Treasuries, with the current rates roughly in the middle of a well-defined channel.

The 2-century charts of long-term U. S. interest rates you may have seen also show that the 30-year bond, trading around 4.6%, is right at its long-term rate. So if you buy TLT, you are basically getting historical yield. You are not accepting the horrible yields available in the short maturities.

Why consider a trade in Treasuries besides playing for support near 90 to hold once again?

Fundamentally, whatever resolution comes from the healthcare reform effort can be good for bonds. If the Senate bill passes, it imposes tax increases before the big spending kicks in. So that's bond-friendly. If it fails, investors can take heart that the ever-expanding Federal behemoth has been stopped in at least one of its growth paths, and thus dream on about smaller government and a longer-term reduction in the tax/spend/borrow dynamic.

Moving to economics, various indicators such as that of the Economic Cycle Research Indicator suggest that the economy is nearing its fastest rate of growth for this cycle, with ECRI's weekly leading indicator showing steadily waning near-to-intermediate term growth momentum.

In relation to stocks, the long bond has a relative valuation that has been good to bond-owners in the past.

In or about 1960, the yield on the long Treasury exceed that on the average stock for the first time in U. S. history. By 1965, it is said that anyone who bought 20-year Treasuries, held for one year, then bought a new 20-year Treasury outperformed a buy-and-hold strategy in the stock market. Certainly, since then whenever Treasuries yielded at least twice the S&P 500 dividend yield, Treasuries were the superior buy. A bit over a year ago, there was a brief time when stocks had fallen so low, with fears of much more dividend reductions, and Treasuries had fallen so low in yield, when dividend yields exceeded long T-bond yields.

Thus we can think of a fundamental range for these different financial assets. If you believe in stocks, buy when dividend yields approach Treasury yields. Be cautious on stocks at a 2:1 yield ratio. Right now, the S&P 500 yields about 2%. The 20-year T-bond yields over 4.2%.

Please remember that with stocks, all a long-term holder keeps in his/her pocket are the dividends. A dividend yield of 2% that grows at 5% per year doubles its yield to 4% in 14 years assuming the stock price stays constant. Remember that stocks historically have yielded 4% as a baseline, and in the roaring '20s, yields of 7% and above were quite common. Thus, stocks may well fall in price even as dividends are increased again.

If you want to get scared about stocks, please click HERE to find historical evidence that a 1/3 drop in the average stock would simply bring stocks back to fair value.

Some final points. If one were to speculate in TLT or its 7-10 cousin ETF "IEF" (which has a "stronger" chart), one can see danger ahead if support were to be broken. This is the near-hyperinflation scenario. Holders of gold or other inflation hedges are especially well-suited to live with that risk.

The other point is that as a continuous holder of bonds, there is no maturity of the bond to bring the price back to 100 (par). Thus there is in theory greater risk in owning a mutual bond fund or ETF than an individual bond itself. Over the short term, however, that risk is negligible, and a discount broker's commission structure plus the ultra-low overhead costs imposed on the ETF, along with minimal bid-ask spreads, make TLT and IEF superior trading vehicles for Treasuries than buying an individual issue. If one really wants to be a long term owner of Treasuries as a portion of one's portfolio, then direct ownership of individual bonds is probably superior to an ETF or mutual fund.

The case against Treasuries can be boiled down to irresponsibility in Washington as well as in the states that ultimately Washington may have to bail out. Plus, whenever Democrats have controlled both houses of Congress and the White House ever since LBJ took office, interest rates have trended upward.

Purchasing TLT and IEF would therefore be seen as a counter-trend purchase, perhaps banking on market hopes for a big midterm sweep for Republicans, in which case history would be much kinder to Treasury holders.

Copyright (C) Long Lake LLC 2010

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